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Long Winded 4% Solution

Not that it matters, but i am making very little progress in trying to straighten out the U.S. Government, the housing mess, etc.. However, If there is anything where i believe i keep getting “push back” regarding much of my argument, it has to do with “who sets mortgage rates” relating to supply and demand issues.

As part of my response to a fellow with whom i am having a pretty decent dialogue going relating to that and other subjects, i thought i would offer you my defense. As usual, i might have gotten “a bit long winded”, so you can just ignore this if you want (if you haven’t already which then you mean that you are not reading this and would not know what i am saying anyway). Regardless, here is the fundamentals behind my argument, including a few sarcastic comments on our fed and other economic experts.

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R—: You’ll have to excuse me sometimes if i repeat myself regarding my argument because i have been talking with several different people of late and sometimes i forget exactly where i stand in a particular conversation. Regardless, with you, i do believe i am further along than with most. And with you i believe i can carry on a “thoughtful” conversation based upon real information.

Now before you begin, i must warn you that i might get a bit long-winded here, but in so doing, i am trying to put as much of my argument down as i can while i think through it.

Starting out, let me be clear, however that i am not an economist; and even though i am a Wharton M.B.A. with a pretty good handle on “finance” and MBSs, just the fact that i am not a phD economist means that i will probably lose out in any argument that i present–whether i am right or wrong. And i especially would lose out to a “nobel prize winning economist” or an ex-chairman of the Federal Reserve (whether that be Volker or Greenspan, who by the way yesterday had a big opinion article in the WSJ talking about Debt–now if that isn’t hootspa, i don’t know what is). Any way, i diverse.

But here is my argument restated or as i explain in Crush Depth Alert. We do not pay attention to the long run in either the past or the future–and that is a mistake. If we had, anyone, even including the Fed would have seen the extraordinary growth in “mortgage debt” over the last twenty years–just as similarly we would recognize that “health care costs” have gone up seven times as fast as inflation over the last fifty years, and now represents 16% of GNP compared to the 5% of GNP back in 1960 (knowing even back then that significant control of diseases like polio, malaria, smallpox, etc. were being conquered).

Now about the 18.0%. First of all, you have to realize that back in the early 1980s, such things as ARM’s and REMICs (or other such derivative products) did not even exist–they came about supposedly as a result of that period of inflation, which as most of us realize, was also brought on as a result of “a spike in oil prices” and “hostage situations” in Iran. I was working at the Department of Energy at that time by the way.

The Fed, including Volker, never understood Mortgage-Backed Securities–their focus has always been more on federal funds rates, inflation, etc. etc. As a matter of fact i saw Volker in front of a Congressional committee this past year talking about financial reform and when asked a question about mortgage rates (including the possibility of lowering them now), he passed on the question, saying that they should ask someone who has more experience and knowledge than he on the subject. Now, some may think that is understandable; however, it is also important to realize that we now have accumulated as much “mortgage debt” as we have “national debt”, which i am sure Volker could have commented on if asked.

As far as my tying 18% mortgage rates to 30 years of 18% inflation, i am not so sure that i am wrong in that. If rates are not tied to inflation for the period they are set, then what are rates supposed to mean. I was always taught that rates were tied to the future cost of money. At least that was what i was taught when we were considering the value of any project and future cash flows and the NPV, IRR, etc. As a matter of fact, the determination of the future discount rate that you used in your assumptions was the most critical factor (and the most argumentable one) used in the entire analysis.

And as far as supply and demand goes–the 18% rate back in the 1980s, essentially shutdown the entire housing market for about three years between 1980-1982. At 18.0% there was absolutely “no demand” for housing, which also had something to do with the recession that we experienced, including decimating or bankrupting many “small farmers” across the country.

When inflation started up, banks who had lended long on mortgages at 7-8% started losing money, when they had to borrow from the Fed at higher rates. Thus they started raising mortgage rates to compensate and the concept of ARMs came into play as a result; however, at the higher rates like i said above, the entire housing market was shutdown. Nobody would borrow at those high rates unless they had to, and the only ones that had to were those who had short term loans that needed to get paid off, then renewed.

Then within one year’s period of time, inflation dropped from around 14% a year to 4% a year. But do you know what happened to long term mortgage rates during that same 10% drop in inflation? They continued to go up until they peaked at 18%.

So there we stood in 1983 with inflation tamed at 4% (which with downfall of the Berlin Wall, China’s coming into some semblance of a market economy, and subsequent globalization) continued at or below that rate ever since. The average inflation rate (based upon the cpi) since 1983 has been 2.99%.

Now if you want to talk about supply and demand, then this is where we should start, because it explains why mortgage-backed securities were always in demand as we continued to increase our debt year after year after year, while Greenspan was getting acolades and we were working ourselves up to the current global financial debt crisis due to that build up.

If you believe long term inflation is going to be 3-4%, it is not very difficult to sell a 18% long term bond to an investor, nor is difficult to sell a 14% long term bond, nor is it difficult to sell a 10% bond, etc. etc. etc. MBSs were always an attractive investment based upon “risk” and inflation. As far as risk goes we were talking about American housing–nothing is safer than that, unless of course you start lending to people that you should not be lending to–(and i do not just mean poor people, but also investors who started purchasing 4-5 condominiums in California, Nevada, Arizona, Florida, etc., thinking that housing prices always go up and never go down).

And so it goes, year after year we slowly lowered long term rates down and had one refinancing period after another. The investor would purchase a 12% mortgage-backed security and two-years later they got their money back. When they looked around as to where they should put their money, there was not much they could do about it–the 10% mortgage-backed security was still a safe bet against inflation, and it did not carry the risk that stocks had. Investing in MBSs made sense in a diversified portfolio and a hedge against long term inflation, whether at 12%, 10%, 8%, 6%, and even now i say at 4%–that is if you believe long term inflation has been tamed–which in fact seems to be the case looking at the last 27 years of history. Yes, as an investor i would have always liked to continue to collect at a 12% rate but that was hardly justifiable.

Now who controlled the setting of these rates. Some people say the Fed did or global demand did. Now i say baloney–fannie and freddie controlled mortgage rates through their underwriting systems. As a matter of fact, if you go into the Feds statistical interest rate database you will find that they get their figures for mortgage rates from Freddie Mac–and have been doing so ever since 1973. Demand was there based upon the argument in my previous paragraph–demand only became dominating over supply when finally we had created so much debt that it finally became a concern.

I would also like to point out that just from “volume” alone, the amount of long-term mortgage debt significantly outstrips the “volume” of long-term treasury debt. As much of the “national debt” is issued at short term rates as it is long term rates, and maybe even more so. All mortgage debt is long term in its nature. And that is why what fannie and freddie were doing was even more important than what the Fed was doing. The banks even worked off of the Freddie numbers that were sent the Fed and continued to be mentioned about every week and every month even now in the press.

Have you ever wondered what goes into a decision as to whether to accept one’s application for a mortgage loan. Of course, you have to consider the person’s income, the value of the house, etc., but sooner or later you have to also decide at what interest rate you are going to demand for that loan. Now how would that be decided? It would be decided in my underwriting system using one factor–my acceptable average mortgage rate for loans over a given period of time. All other risk criteria would work off of that. I sure don’t think that fannie and freddie continuously went in and adjusted 100 risk factors in their underwriting systems, instead they adjusted one (the acceptable average mortgage rate), and all the other 100 risk factors worked off that one.

Back in 1988 when i started working with Ginnie Mae, there used to be a rule of thumb that the half-life on a mortgage backed security was 8 years–that is the half life. And generally speaking that was the reason people related them to 10-year Treasury notes. Well, in truth, due to all the refinancing we have experienced in the last twenty-five years, the half-life of a mortgage-backed security became less than two years.

In 1989, one of the first graphs i ever plotted was the paydown history of MBSs that were issued between 1970-1989. Do you know what it showed. It showed that essentially the paydown on loans issued in the 70s was much, much slower than the small limited number of loans issued in the early 80s. Essentially any loan that was issued at the 18% rate had completely paid down. I used to call this graph the “Big W” graph, and i still have it around, so i will try to send it to you separately when i figure out how to do that. But, anyway, this Big W graph, if you understand it, essentially shows the difference between a portfolio of loans that can refinance versus a portfolio of loans that cannot refinance.

And if you understand the Big W graph, you will also understand how with that knowledge you could construct something like a REMIC (which by the way was created through fannie and freddie) and use that knowledge to your advantage–like what i say fannie and freddie did.

So year after year, the Fed being asleep, allowed fannie and freddie to lower mortgage rates year after year after year, jacking up Mortgage Debt in the U.S., which was jacking up the economy for Greenspan, who was getting acolades. If you want to talk Keynesian economics, when thinking of Greenspan you have to consider the $1.0 trillion of “national and mortgage debt” that was being thrown into our economy year after year throughout his entire reign. And it also worth noting that that $1.0 trillion debt should be put into relation to a GNP which was around $10-$14 trillion during that period (and thus somewhere between 7-10% of GNP).

Let me also let you know this. Our analysis in the 1990s always showed that ARM loans performed worse than fixed loans, even though, the rate on ARM loans were still below that of fixed rate loans–most of that can be attributed to “teaser ARM loans”, and the fha and va essentially shut down their ARM loan programs and only went to fixed rate loans.

And despite what people think about Government involvement in housing, the fha and va programs outperformed fannie, freddie, and the big banks–while serving a population that is generally assumed to be poorer than the clientele of fannie, freddie and the big banks. After all, you have to realize you wouldn’t go to the fha and va unless you couldn’t get approved through a conventional loan process–and i know this somewhat from experience as a veteran who got his first mortgage loan through the va because i could not qualify for a conventional loan (but that was back in 1985 before fannie and freddie and the big banks started playing their games). I also know this from my 12-years of watching fannie and freddie strip the fha and va of their best loans during the refinancing periods. I also know this same thing held throughout the first decade of this new millenium.

Oh well, as i said at the start, i know this is a bit long-winded, and i hope you excuse me for that. But i think it does begin to explain a little more about where i am coming from.

I would be happy to comment on issues on your website where our dialogue can be shared with others, but as you can see from the above (and we have just begun to talk) that a lot of background needs to be set before everyone is talking from the same basis–at least from my perspective.